‘Kelly’s Know-how’ – November 2020 edition
Spotlight on pensions
With so much jargon, and different terms used to describe the same things, the world of pensions can be quite baffling! This month, let’s go back to basics and look at the different types of pension, and what they can mean for your income in retirement.
What are the different types of pension?
First of all, there are two main categories of pensions:
- Defined benefit pension
- Defined contribution pension
‘Defined Benefit’ or ‘Final Salary’ pensions are a form of guaranteed income for life. When you reach the nominated retirement age, you will be paid a monthly income for the rest of your life based on your pre-retirement salary and the length of your service.
For employers, there is a high unknown cost to maintain a ‘Final Salary’ pension scheme, which means that this kind of scheme is now rare, with employers taking a more manageable option.
A ‘Defined Contribution’ or ‘Money Purchase’ pension is a pot of money that you can use when you retire. It’s based on how much money has been paid into the pot, and the investment performance.
Unlike annuities or final salary pensions, defined contributions pensions do not have any guarantees of income. Once the pot runs out, there is no money left.
Before the pensions freedoms introduced by the government in 2015, the only option you had with your ‘Defined Contribution’ pension was to use the money in the pot to buy an annuity, i.e. exchange the capital for a regular income for life. This might be a suitable option for some people, however, it can create problems such as loss of capital.
The pension freedoms granted the freedom to access your ‘Defined Contribution’ or ‘Money Purchase’ pension pot in whatever way you want, as long as you have reached the minimum retirement age, which is currently 55.
You could therefore exchange your pot for an annuity as before, take some income, take some lump sums, leave it untouched or even take everything in one go.
Your pension provider needs to offer a ‘flexi-access drawdown’ feature so that you can fully benefit from this flexibility. Remember that, although this was introduced by the Pension Freedoms Act 2015, pension companies are not legally obliged to offer this feature. This means that if your pension plan was taken out before 2015, it might be that you do not have the ‘flexi-access drawdown’ option available.
Taking money out of your pension
Normally you can withdraw 25% of your ‘Defined Contribution’ pension pot completely tax free. This does not mean that you have to take the full 25% all at once.
Let’s look at an example:
You have a ‘Defined Contribution’ pension currently worth £500,000. You could take the maximum tax-free cash of 25%, or £125,000.
However, say you only need £50,000 to pay off your mortgage. It is therefore wise to only take £50,000 tax free cash and withdraw more when you have some expenditure in the future.
To withdraw this, you need to crystallise (open your pot) £200,000, so that you can take 25% tax free cash from it, i.e. £50,000 and leave the remaining fund of £150,000 in drawdown. If you withdraw money from drawdown pot, it will be taxable at your marginal income tax rate.
You will also have the other £300,000 uncrystallised (untouched pot). In 5 years’ time, your £300,000 might have grown to £350,000, for the sake of this example. This means that you could now withdraw 25% (£87,500) tax free cash from the current value of £350,000.
In summary, it is not always the best option to withdraw your full tax-free cash allowance if the money is not needed. You can leave the pot of money to grow and then take the 25% tax free of the fund value then. Of course, growth is not guaranteed, but if you have taken sage advice, invested wisely and diversified, you have given yourself the best chance of seeing your money grow.
Looking further ahead
Another benefit of a ‘Defined Contribution’ pension is in estate planning. The money in a ‘Defined Contribution’ pension pot can be left to the next generations, free of inheritance tax (IHT).
For people who have substantial other assets available, leaving the pension fund to the next generation could be a really efficient way of passing down wealth, without a huge tax bill.
In summary, ‘Defined Contributions’ pensions:
- are the most common pensions nowadays
- offer flexibility when you need to draw out money
- can run out of money if drawing out too much or investments do not perform well
- can be left to the next generations
One thing is certain – pensions can be quite complex! I hope the above has given a nice overview of the different types of pension and the options available. If you have ‘Defined Contribution’ pensions, it is a good idea to check that they are still suitable and offer all the features that you need for your current circumstance, particularly if you have several, or have held them for a long time. Make sure you contact us for more help!
Next month, we will talk about what happens to your pension when you get older, on death and some key things everyone should be aware of!